Stablecoin adoption & TradFi

           The impact of stablecoins on banks:

Are stablecoins the killer DeFi application and what, if any, is the impact on TradFi if they achieve mass adoption? That is the topic that I have been pondering and I want to share some of my thinking... not as conclusive arguments but more as food for thought.

Stablecoins are not all created equal, they can be roughly categorized into three main categories:

1) Majority backed by liquid fixed-income instruments (e.g. USDC, USDT, BUSD). In effect, these stablecoins and their issuers are the CeFi equivalent of TradFi money market funds (without the yield).

2) Multi-collateralized stablecoins (e.g. DAI, LUSD) where the value of the collateral/backing for the stablecoins in issue can be somewhat more volatile and/or less liquid and this is addressed through over-collateralization and AMM algorithms to protect the principle & peg.

3) And lastly, algorithmic stablecoins where the peg is primarily algorithmically secured, which to date has seen the biggest failures (UST/Luna, Titan, ESD).  That said, protocols like FRAX continue to pursue this holy DeFi grail today.

Arguably there is one stablecoin category still "missing", those issued by TradFi whether that be a central bank or a commercial bank. The latter may be close if companies like Circle or Paxos get full banking licenses and/or central banks start rolling out their CBDCs.

Let's not go down the rabbit hole of the pros & cons of multi-collateral and algorithmic stablecoins, and stick to the first category for now as those are the most established today... Comparing these stablecoins to bank balances or money market fund investments from a retail or SME perspective is quite interesting at this particular point in time.  They provide superior yield if deployed in low-risk DeFi yield strategies or held at a centralized exchange (e.g. Binance or Coinbase) or DeFi lending operator (e.g. BlockFi).  One obviously assumes some smart contract or counter-party risk when doing so, but one could argue that is no different with an investment in a money market fund or a deposit at a deposit-taking institution (a.k.a. TradFi bank). The point, however, is that you can send stablecoins across the globe in a permissionless way at a pretty low cost (depending on which chain/layer you use) and you can switch between currencies pretty easily through centralized or decentralized exchanges.  Although that does not amount to much for those that reside in nations with developed banking infrastructure and relatively stable currencies it is an absolute game-changer for those in developing markets, especially those with rapidly devaluing currencies.  

The thesis is that access to USD, EUR, and other major currency digital asset equivalents with positive yields combined with affordable and permission-less underlying payment infrastructure is a game changer.  

Note that although the Bitcoin & Ethereum network could facilitate such purpose, the inherent volatility of their native tokens makes the tokens themselves less useful for such purpose, and the fact that most global trade is still priced in major currencies and not in BTC or ETH, makes stablecoins the more "usable" digital asset at this particular point in time.  Imagine a merchant in Turkey or Venezuela wanting to import and pay for Chinese goods or indeed a foreign entity wishing to pay for services in such a country... Banking and FX charges on hard money reserves/payments would likely be crippling and that's before exchange controls, whereas stablecoin crypto payments are virtually hassle-free the only issue being that you still require the FIAT on/off ramp to bridge the crypto to the real world (FIAT) at some point.

Now let's look at what is going on at TradFi banks.  From the above read, it should be clear that more and more of the traditional banking services are being disintermediated by technology with more nimble fintech players trailblazing the use thereof. Cross-border payments and FX are being disintermediated, there is increasing non-bank competition in services such as cash management and treasury operations as well as credit creation in traditionally lucrative sectors such as asset-backed & mortgage lending and there is ample competition for deposits through higher yields in DeFi. The drivers of change differ by market. Customers in developed markets (with highly efficient payment rails) are looking for higher yields on their savings/deposits, whilst customers in developing markets are looking for safe havens against local currency debasement, more efficient payment rails, and lower costs.  Slowly but surely, however, proactive customer behavior and fintech innovation is eating away at the earnings base and profitability of traditional banking.  This deterioration of earnings power can be most clearly seen by looking at price-to-book (P/B) multiples of commercial banks in Europe.

Today most European banks trade at a discount (often 50% or more) to book, as seen in the chart below, and P/B ratios of euro-area banks have remained at a discount to book ever since the financial crisis of 2007/8 (ECB Financial Stability Review, May 2019). But what does this mean I hear you say? Think of a bank simplistically as an entity that is in the business of selling/creating loans (credit creation). If the bank makes good loans they are repaid at maturity and the bank earns interest on the outstanding balance (interest income). The bank "funds" these loans through its balance sheet comprising primarily three sources 1) equity or tier 1 capital (usually less than 10% of the balance sheet), 2) deposits i.e. other people's money on which they pay interest (deposit rate) and lastly 3) money that the banks themselves borrow in the institutional/capital market for which they pay a market interest rate.  Note that the deposit rate is usually lower than the market rate hence banks' usual keenness to attract retail deposits as they represent a "cheaper" source of funding to the institutional/capital markets.  

There is of course one other "source" of funding, the central bank. This is the real-world equivalent of a testnet faucet available only to regulated/licensed banks where they can exchange pretty much any asset/collateral that they have on their balance sheet for liquid reserves which they can then use to settle balances with other financial institutions thus backstopping the liquidity of the banking system.

So if we take a simple bank with a tier 1 ratio of 10% and a further 20% of its balance sheet funded by deposits, and a balance of 70% in institutional debt you can imagine the cash flow waterfall from the earnings income generated from its lending activities... Firstly the interest on the institutional debt needs to be paid, then the interest on the deposits (remember these are unsecured creditors) needs to be paid and what is left accrues to the equity holders. A bank trading at a discount to the book value (of equity) is essentially the manifestation of equity investors saying that the return on the book value of the equity (historical value at which it was raised) is less than the expected (market) return... sort of like a bond trading at 50ct on the dollar because the coupon is only half of the prevailing yield on the secondary market.  So you're sat there thinking what does all this mean?

It means that by and large, banks (certainly in mainland Europe) notwithstanding their preferred access to cheap funding through institutional and central bank lending and the profiteering from payment of sub-market deposit rates on bank deposits, cannot earn a return on their regulated capital that is in line with market expectations (risk-free rate + equity risk premium)...and all that is before we get into the actual creditworthiness/value of the assets on their respective books.

So if banks add little to no economic value from an equity perspective and the inversion of the global yield curve (increasing short-term cost of funding and deposit rate expectations) is putting further pressure on their business model, are your savings really better off as deposits (subordinated credits to a bank) than in a transparent stablecoin or money market product? Once people start realizing these simple truths and see the systemic risks banks pose through the leverage on their respective balance sheets, I believe more and more people will opt to keep increasing amounts of their assets/wealth on-chain. As people migrate on-chain and realize they can interact as easily on-chain as through banks, banks will gradually be starved of funding and income and slowly but surely They will have rightsize to the economic value they create.

It is my contention that this revolution will be led by emerging markets where the use cases and the economic incentives are the most compelling.  Although relatively small in volume/size compared to developed market trade flows and balance sheets the next wave of crypto adoption will be led by institutions that facilitate stablecoin usage & payments in a non-fractional reserved & on-chain manner.  These flows will be more efficient and transparent, reducing the requirements for leverage and central bank intervention/support, and will drive further global adoption. The future is bright, the future is on-chain.


Financial Stability Review, May 2019
The European Central Bank (ECB) is the central bank of the 19 European Union countries which have adopted the euro. Our main task is to maintain price stability in the euro area and so preserve the purchasing power of the single currency.